The Good, Bad and Unexpected of Fiscal Rules

Fiscal rules can improve fiscal results, but they can also have unintended consequences

Caribbean countries still face a delicate fiscal situation. While a number of Caribbean economies have reduced their debt burden, the majority face high sovereign debt levels that weigh on their prospects for strong and sustainable growth. In the context of weak fiscal stances and high dependence on foreign external conditions, it makes sense to implement fiscal rules that would allow these countries to keep spending under control and to save in good times to face potentially challenging times ahead.

To help with that quest, the IDB’s Fiscal Management Division and its Country Office in The Bahamas hosted a meeting Dec. 4-Dec. 5 with finance ministers and officials from around the Caribbean to consider fiscal rules, medium-term fiscal frameworks, and stabilization funds. Present at the conference in The Bahamas were some of the most knowledgeable experts in the field from outside the IDB, as well as IDB specialists.

The sessions explored some of the key issues in the design of fiscal rules, the conditions that favor their implementation and their functioning, and the main issues behind their enforcement. This included discussion of the many forms rules can take, from more strict numerical ones to longer-term and planning-based medium-term frameworks.

Fiscal rules can improve budget balances 

The IDB’s Research Department (RES) has a more than 20-year history of leading and accompanying investigations into fiscal rules, beginning in the late ‘90s when it led the first analysis of their impact on the region. The evidence at the time indicated that fiscal rules were important to improving fiscal results. I evaluated the effectiveness of such rules a decade later for the 10th anniversary of RES and found that evidence to be still strong. More recent work by RES colleagues shows that fiscal rules, particularly medium-term frameworks, can play an important role in improving budget balances.

Over the years, the analysis has shifted somewhat. It has moved from the evaluation of the impact of fiscal rules to understanding the conditions under which they work and they don’t. As we discuss in our book, Who Decides the Budget? it is not only the existence of clear enforcement mechanisms that matters. Also essential is the presence of the right political incentives. If rules are introduced within the same set of political incentives that generated unsustainable fiscal outcomes in the past, there is a high likelihood that they will fail. Indeed, cases abound where countries pass a fiscal rule only to violate it soon thereafter, then pass a reform to the original law, only to violate it once again.

 Timing is crucial  

The timing in the introduction of rules is thus crucial to their effectiveness. As expert Teresa Ter-Minassian noted during the meeting, the best time for introducing rules, like structural budget balance ones, is in good times. That can enhance credibility and generate the right conditions for dealing with a downturn when it comes. Unfortunately, this is rarely the case. Just as we are less likely to change habits when we are doing well in our personal lives, governments are reluctant to change when things look bright. Rather, as we have shown in a relatively recent paper, they are more likely to introduce fiscal rules during fiscal crises, when the markets push them to do so. The problem with that is that by then, credibility has taken a hit, and the adjustment tends to be more difficult.

Finally, it is worth noting that sometimes even the best-designed rules can have unexpected consequences. As I discuss in a paper written with Martin Ardanaz, fiscal rules can change incentives in unpredictable ways. A prime example is what happens when the executive branch is given relatively greater power in the discussion and approval of the budget than the legislature. This may help keep the budget under control. But it also can create a reason for the executive to propose higher expenditures that will reap political benefits that used to accrue to the legislature.

The incentives of political actors affect reform 

Fiscal rules are difficult to design, difficult to pass into law, and can have unexpected impacts once enacted. Still, they are necessary in countries that are prone to fiscal mismanagement. As I have argued before, fiscal and public finance management reforms can bring benefits even beyond their narrow confines. But in order for these reforms to be successful, we must understand the incentives of political actors and the conditions under which these changes can prosper. “Development partners such as the World Bank, the IDB and the IMF need to make assessments of political institutions as well as technical issues when offering advice to LDCs (Least Developed Countries) on reforms favored by the governments concerned,” I have written. “In turn, these organizations need to supplement the abundant professional skills they have built up in economics and accountancy with other skills – notably political science and change management.” Only by understanding the multiple challenges, as well as the multiple potential benefits, will we be able to help countries advance significantly in their quest for fiscal sustainability.

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The Author

Carlos Scartascini

Carlos Scartascini

Carlos Scartascini is Leader of the IDB Behavioral Economics Group and Principal Technical Leader at the Research Department of the Inter-American Development Bank. He is currently focused on expanding the use of behavioral economics at the IDB and leading many field experiments with governments in Latin America and the Caribbean. His current research focuses on the role of messages and methods of communication to affect behavior and demand for public policy. In addition to Behavioral Economics, his areas of expertise include Political Economy and Public Finance. He has published seven books and more than 35 articles in edited volumes and specialized journals. He is Associate Editor of the academic journal Economía. A native of Argentina, Carlos holds a Ph.D. and a M.A. in Economics from George Mason University.

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